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An analysis of the effect of discretionary cash on the earnings response coefficient
Abstract
This dissertation is a test of a recent sequence of theory by Holthausen and Verrecchia (1988), Lev (1989), and Choi and Salamon (1989), which suggests that the market reaction to an accounting earnings announcement is a function of unexpected earnings and a firm's earnings response coefficient, where the earnings response coefficient is a function of the uncertainty of the firm's future cash flows and the information system noise of the firm. In order to empirically test this theory, a situation in which the uncertainty of future cash flows increased was examined. The situation analyzed was where discretionary cash (an increase in funds which management has discretion in the use of) increased significantly. This increase in discretionary cash was expected to create an agency problem similar to free cash flow as described by Jensen (1986). Using the dispersion of analyst forecasts as a measure of the uncertainty of future cash flows, the effect of discretionary cash on the future uncertainty of cash flows was tested. The results showed that the mean dispersion increased significantly for the sample firms after the sell-off which created the discretionary cash, and at the same time did not significantly change for a matched set of control firms. These results lend support to Jensen's free cash flow theory, and indicate that in certain situations changes in cash can affect firm risk. Using a linear regression model, an empirical test of the relationship between the earnings response coefficient and the uncertainty of future cash flows was also performed. Using annual announcements, the model became more significant after the increase in discretionary cash. With quarterly announcements the earnings response coefficient changed after the increase in discretionary cash, but the change was not in the direction expected. Overall, these results indicate that the uncertainty of future cash flows does affect the earnings response coefficient; however, the direction of the change was not consistent across annual and quarterly data.
Subject Area
Accounting
Recommended Citation
Harter, Charles Ives, "An analysis of the effect of discretionary cash on the earnings response coefficient" (1991). ETD collection for University of Nebraska-Lincoln. AAI9200138.
https://digitalcommons.unl.edu/dissertations/AAI9200138